Vale's (NYSE: VALE) shares remain under pressure following the continuing slump in iron ore prices. Currently, Vale's stock is falling victim of the problem that the company helped create - the chronic oversupply in the iron ore market. Once again, Vale delivered record iron ore production in the third quarter, producing as much as 85.7 million tons of iron ore. Despite falling prices, Vale continues to increase its iron ore production further.
The company's biggest move is scheduled for the end of 2016, when Vale's flagship iron ore project S11D should start production. Vale stated that this project achieved 37% of combined physical progress in the third quarter. Production at S11D should reach 90 million tons annually at full capacity. Given the size of the project, S11D is Vale's top priority. When asked about the project during the third quarter earnings call, Vale stated that it was no way that the company reduced the pace of investment in S11D. The company also stated that it believed that production from S11D could substitute the production outside Vale. This is exactly what the company is hoping for while increasing its iron ore production quarter by quarter.
The idea is simple: weaker players leave, Vale achieves big market share and enjoys improved prices. The exact same plan is probably in the minds of other big players like BHP Billiton (NYSE: BHP) and Rio Tinto (NYSE: RIO). In theory, the idea sounds good, but in practice, things are not that rosy. At some point, the increased production is unable to compensate for lower prices, at least in the short term. Vale produced $4319 million of operating cash flow in the third quarter of 2013. This year, third quarter operating cash flow stood at $2942. I see little signs that iron ore rebound will happen soon as big players continue to flood the market with production and keep telling investors that they are happy doing it. Vale relies on the economies of scale, and its third quarter iron ore cash cost was $24.7 per ton. Even taking into account the fact that Vale has to ship its ore to customers, the company has significant cushion should iron ore prices slip even lower.
However, as prices drop, the stock follows. In fact, Vale's shares currently trade at levels seen at the end of 2008. Yes, the company pays a dividend, whose minimal level is proposed at the beginning of the year. This year, Vale distributed $4.2 billion in dividends. Those who buy Vale's shares at current levels could enjoy juicy yields if this dividend is reiterated in 2015. However, the story of Seadrill (NYSE: SDRL) has taught investors how easy a big dividend could be cut to zero if market conditions are bad. I'm not stating Vale will eliminate its dividend, but the company will surely examine a decrease of the dividend from this year's level and could come to a decision to save some cash. Vale needs to finance its most important growth project, and this will remain the top priority for the next two years.
I think that iron ore market will remain depressed in the near to mid-term because of the constant addition of new supply from the big miners. I also don't think that weaker players will be fast in cutting their production. The story of coal highlighted the fact that weaker companies are reluctant to cut production until they are absolutely in dire straits. Therefore, I think there is uncertainty about Vale's future dividend level as the company is betting heavily on iron ore. In my view, this uncertainty will continue to weigh on Vale's shares in the coming months.
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